Tuesday 8th April 2008
The Financial Fortnight That Was
In This Issue
Financial Topic Demystified - Value Investing
Market News
Opes Prime - or sub prime?
Quick Links
 
 
Greetings! 
 
Welcome to the latest edition of The Financial Fortnight That Was.  This edition looks at a value approach to investing, provides a summary of the movements in markets over the past fortnight and looks at the impact of the collapse of Opes Prime. We hope that you find the material informative and relevant.  Enjoy the read!
 

A Quote for Consideration

"We can extrapolate from the study that for the long term individual investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100% of performance."

 

Roger Ibbotson, Ibbotson Associates

The True Impact of Asset Allocation on Returns (2001)

Financial Topic Demystified 
Value Investing
 

If you scan through the offerings of fund managers, including those who favour direct equities, it won't be long before you come across what is referred to as a "Value" fund or approach.  So what is a value investment approach and how can it be successfully used within investment portfolios?

 

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The idea behind a "value" approach to investing is that companies that currently seem out of favour with the market will provide a higher return going forward.  In 1987 Michelle Clayman published a study in the Journal of Finance (Volume 63, May-June). The article looked at the performance of a group of 29 "excellent" companies - using the criteria for an excellent company as identified in a New York Times best-seller written in 1982 by Tom Peters and Bob Waterman entitled In Search of Excellence. The criteria for excellence included average return on capital, average return on equity and compound asset and equity growth.

 

Using the same formula, Clayman identified the 29 worst stocks and called these the "unexcellent" companies. She then compared the investment return of the portfolios of the "excellent companies versus the unexcellent companies". From 1981 to 1985 the "unexcellent" companies outperformed the S&P 500 by 12%, while the "excellent" companies outperformed the S&P 500 by only 1%. The conclusion can be that the supposedly "unexcellent" companies are often so ignored by the market there is scope for strong returns when they do produce good financial results.

 

Another earlier study looking at value stocks was conducted by Paul Miller in 1964. Miller compared buying the 10 lowest and 10 highest price/earnings (P/E) stocks of the Dow 30 from July 1936 to June 1964. The P/E multiple is the price of the company divided by its earnings. A lower P/E is another definition of a value stock. He found the 10 lowest P/E stocks greatly outperformed the 10 highest; however, the lowest 10 P/E stocks also had a greater volatility of returns. This identified that returns for these stocks were more volatile, suggesting there was a greater "risk" in holding these shares.

 

In 1992, professors Gene Fama and Ken French published the paper the Cross-Section of Expected Stock Returns, in the Journal of Finance. This paper was the winner of the Smith-Breeden prize for the best paper in the magazine that year. The paper looked at returns for individual shares in the US sharemarket between 1963 and 1990. It found that:

         Small companies had a higher expected return that large companies.

         Value companies had a higher expected return than growth companies. The paper defined value companies as those with a low price to book ratio; that is; the share price of the company traded closer to the value of its assets than a growth company.

 

This group of evidence all suggested that value companies do have a higher expected return and therefore value is likely to be an area of the sharemarket that would make sense for people to invest in.

 

However, we must bring the discussion back to one of the fundamentals of investing, the trade-off between risk and return.  For a company or group of companies to have higher expected returns going forward compared to the market average they must, by definition, be a riskier investment. These companies are out of favour for a reason due to current market conditions or company specific issues.  A current example is the banking and finance sector.  The sub-prime collapse and ensuing credit crunch has caused difficulties for these type of companies.  Some have experienced extreme distress, take Bear Stearns in the US for an example.  However the expectation is that through good management and a change in economic conditions the vast majority of these companies will pull through and in doing so outperform the market because they are coming from a lower base.

 

With this in mind it is important to make sure that a value approach investment is well diversified by investing in a range of different companies as well as being used in conjunction with investments in less riskier assets such as an index fund based on the top 100 or 200 companies in the ASX.

 

Scott Francis provides an analysis of one approach to value investing in one of his latest Eureka Report article - Can market 'dogs' outrun the rest.  Well worth a read.

 

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How Do We Apply This?

 

We access this value premium through Dimensional Fund Advisors.  They have established an Australian and a Global Value Trust.  Both trusts are extremely well diversified with the Australian trust containing 183 holdings and the Global trust holding 816 holdings as at the 29th February 2008.  This is particularly important given the extra risk that is being taken on by an investor.  Diversification helps to smooth out the volatility caused by an individual company while reducing the impact caused by any one company falling over.  To see the results of the two funds since inception please click on the following link:

 

Dimensional Funds Performance Graphs

 

On the Lighter Side

Sometimes your best investments are the ones you don't make.

Market News
 

Market Indices

Since our previous edition, Australian and global sharemarkets have experienced strong upward movement.  The S&P ASX200 Index has risen 9.60% from the 21st of March to the 4th of April.  It is now down 7.83% from the same time last year and down 11.36% for the calendar year (2008) so far.  The MSCI World - ex Australia, a measure of the global market, has risen 5.52% over the same period.  The index is down 9.09% from the same time last year and down 8.69% for the calendar year so far.

 

Emerging markets have also experienced positive movement with the MSCI Emerging Markets Index rising 7.41% since the 21st of March.  It is up 14.92% from the same time last year but down 8.85% for the calendar year so far.

 

Property trusts have continued to experience positive movements since the 21st of March with the S&P ASX 200 A-Reit Index (formerly known as the Property Trust Index) rising by 8.19%.  However, the index is down 28.41% from the same time last year and also down 17.39% for the calendar year so far..  The S&P/Citigroup Global Real Estate Investment Trust (REIT) Index, a measure of the global property market, has risen 5.70% over the same period.  It is down 19.83% from the same time last year and now only down 0.08% for the calendar year so far.

 

Exchange Rates

As of 4pm the 4th of April, the value of the Australian dollar had fallen slightly since the 21st of March with the Aussie dollar down 0.40% against the US Dollar at .9117.   It is up 12.28% from the same time last year and up 3.41% for the calendar year so far.  Since March 21st the Aussie has fallen 0.15% against the Trade Weighted Index now at 68.8.  This puts it up by 3.77% since the same time last year and up only 0.15% for the calendar year so far.  (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)

 

General News

Since our last edition the board of the Reserve Bank of Australia have decided to keep official interest rates at 7.25%.  In a brief statement the Governor of the RBA, Glenn Stevens, informed that the decision was made because the tightening of financial conditions, including RBA monetary policy, had been substantial since the middle of 2007.  This tightening is working to foster a moderation in demand growth that will take pressure off inflation.  He suggests inflation should decline over time, provided demand slows as expected and as a consequence the current level of the RBA policy interest rate was appropriate.

 

 
Monday's Money Minute Podcats Update
 

In the most recent podcasts, Scott Francis looks at Lessons from the Opes Prime collapse; and a second podcast looking at the best researched portfolios in the world.

 

Click here to be forwarded to Monday's Money Minute Podcasts

 
Opes Prime - or sub prime?
Scott's Financial Happenings Blog - Posted Sunday 30 March
 

The biggest story in financial markets today is the collapse of Opes Prime, a broking house with more than 1,000 clients.

 

Opes Prime was a 'prime broking house'.  In short this meant that it was more aggressive than a retail broker, with a focus on stock lending and borrowing to invest.

 

Unfortunately for the clients of Opes, their stocks actually secured some of the overall loans that Opes used.  So, with the collapse of Opes, their portfolios were put in the hands of the banks (ANZ and Merril Lynch) to sell shares to be repaid.  The clients were effectively unsecured creditors in the whole process - and now wait to see what money they will recover.

 

All this brings to a head the importance of being careful when you borrow to invest.  It is a risky strategy - sure it is great when asset prices are heading north.  However, when they head south it can get very ugly.  You might end up like the Opes clients - forced sellers of assets in a downward market.  This is not a pretty situation at all!

 

At the end of the day the simple, steady approach is pretty bulletproof.  Spend less than you earn.  Invest regularly in growth assets.  Keep short term cash needs in a cash account.  Be well diversified.  Keep costs low.

 

Regards,

Scott

 

Other blogs over the past fortnight:

 

30th March - They need a good financial adviser - not a lawyer!

31st March - ASIC announces Pie in the Sky Awards for 2008

1st April - Planning for retirement in style

3rd April - Women - scared of investing or just in need of better alternatives?

3rd April - Why commissions don't work - Opes Prime case study

Scott Francis interviewed on Channel 9's Brisbane Extra

Since our last edition Scott Francis has been interviewed for a Channel 9 Brisbane Extra story on Equity Finance mortgages.  Click on the link below to be taken to a transcript of this story:

 

Mortgage Option

 : Scott was interviewed for the program to provide some brief analysis of these style of mortgage products.
Eureka Report Articles Update 

Since our last edition Scott Francis has contributed two articles to Alan Kohler's Eureka Report.  Click on the links below to be taken to these articles:

 

Can market 'dogs' outrun the rest - Maintaining a portfolio of the market's 10 highest-paying value stocks can offer outperformance; it can also be very volatile.

 

Margin loan? Think again - Investing regularly in growth assets is a powerful and simple wealth-creation strategy free of the risks of margin lending.

Click here to be forwarded to Scott's Eureka Report Articles

We hope you have enjoyed reading the latest edition.  If you have any comments or suggestions for future topics please do not hesitate to get in contact.
 
Have a great fortnight!
 
Cheers,
The Two Scotts
 

The Financial Fortnight is a publication of A Clear Direction Financial Planning.  It contains general financial advice.  Readers should check this advice with a professional financial adviser before acting on any of the material contained in this email.

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